A Closer Look At Discover Financial’s Credit Card Business

Discover Financial’s (NYSE:DFS) stock has gained more than 30% since the turn of the year helped by improving consumer trends and a strong performance delivered by the company through the first half of the year which led to a 10% increase in revenues and net income. Discover has been expanding its direct banking business offering personal loans, student loans and home loans, but credit cards remain its main business. Nearly three-quarters of Discover’s revenues through the first six months of 2013 came from interest income on credit card loans, which grew 3% over the prior year. Discount and interchange revenues accounted for 15% of the company’s revenues and grew 11% over the prior year.

Our $47 price estimate for Discover Financial is in-line with the current market price.

See our complete analysis of Discover Financial here

Small Market Share Is Not A Bad Thing

Discover is a relatively small player in the credit cards domain with just around 70 million cards in circulation. ^[1] In comparison, Visa has 278 million credit and charge cards in circulation in the U.S. while MasterCard has 180 million. ^{[2] [3]} Visa and MarterCard process roughly 38 transactions per card annually whereas Discover processes 32. The average payment volume per transaction is around $50 for Visa and $60 for both MasterCard and Discover. Discover’s market share in the U.S. is just around 5% of the credit purchase volume.

However, this selective strategy has actually helped Discover manage risk. The delinquency rate or the percentage of total loans that are past due date on credit card loans for all commercial banks in the U.S. is around 2.52%. Discover’s delinquency rate is much lower, around 1.6% for loans 30 days past due date and 0.8% for loans 90 days past due date. Delinquency rates in the U.S. have been declining since the 2008 financial crisis as consumers are now more aware of the dangers of defaulting on a loan. The rate was around 6.8% in 2008. ^[4] Lower delinquency rates will ease pressure on the reserves maintained by the company for loan losses.

Increased Spending Will Help Discover

Discover’s balance sheet shows nearly $50 billion in credit card loan receivables on which the company earns an interest of close to 10%. The company’s market share is around 5.5% of the total revolving credit owned and securitized, outstanding across the U.S., a figure that it has maintained for the last four years.

Consumer spending trends in the U.S. have improved over the last few years partly due to the Fed’s Quantitative Easing programs designed to increase liquidity in the market. Personal consumption expenditures (PCE) as a percentage of actual disposable income in the U.S. (the income available to an individual for spending after paying taxes) dipped from 96% in 2007 to 91% in 2008 and 2009. However, the percentage has improved back to 94% in the last three years. ^[5]

Total revolving credit dropped from 10% of disposable income in 2008 to 8.21% in 2012. This is partly due to increased popularity of debit and pre-paid cards among consumers in the U.S. Transactions on debit cards now account for 42% of Visa’s (NYSE:V) nominal payments volume in the U.S. as opposed to 22% outside the U.S.

The unemployment rate in the U.S. has recovered from the peak of 10.1% during the financial crisis in 2009 and reached a four-year low of 7.3% in August. ^[6] An improving job market should lead to higher disposable income in the future. The per capita real disposable income dropped 3% from 2008 to 2009 but has since been growing at an annual rate of 0.7% in the last few years. We expect a near term growth rate of 0.7% followed by a long term growth rate of 1%.

If Discover maintains its market share of 5.5% of total revolving credit, it can reach a loan balance of $58 billion by the end of the decade. A net interest yield of 10% will lead to around interest income of $5.8 billion.

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1. Visa 10K [↩]
2. MasterCard Q2 2013 Financial Results, Operational Performance (reported July 31, 2013) [↩]
3. Visa Operational Performance Data (reported July 24, 2013) [↩]
4. Delinquency Rate On Credit Card Loans, All Commercial Banks, Board of Governors of the Federal Reserve System [↩]
5. Disposable personal income, U.S. Department of Commerce: Bureau of Economic Analysis [↩]
6. U.S. Department of Labor, Labor Force Statistics from the Current Population Survey [↩]